Six months ago, the Federal Reserve lent JPMorgan Chase & Company $29 billion to engineer its shotgun takeover of Bear Stearns, the venerable but deeply troubled Wall Street firm.
Less than one week ago, the Treasury pledged up to $200 billion to rescue Fannie Mae and Freddie Mac, the giant mortgage finance companies.
But as policy makers tried to engineer an eerily similar takeover and rescue for Lehman Brothers, Treasury and Fed officials told the company and its potential suitors on Friday that the government had no plans to put taxpayer money on the line.
Perhaps the biggest reason for the sang-froid is that Fed officials as well as Wall Street institutions had months of advance warning about Lehman’s problems and far more time than they had with Bear Stearns to assess the potential domino effects, or “systemic risk,” that a collapse might pose.
By the time Lehman’s shares went into a spiral this week, Fed and Treasury officials were convinced that Lehman posed far fewer real risks than Bear Stearns had back in March.
The confidence by Washington officials stemmed from the fact that, after the Bear Stearns collapse, they obtained stronger regulatory powers that gave them the ability to peer into the activities and risk exposures of institutions on Wall Street.
Fed officials, for example, are now embedded at each of the big Wall Street investment banks and have at least some capacity gauge the firms’ exposure to hedge funds and other big players, as well as their positions in financial derivatives and other opaque markets. Fed and Treasury officials have also been taking the daily pulse of executives and traders on Wall Street for months, and much of that discussion has been about Lehman.
Officials detected a rising number of defections by Lehman’s institutional customers to other firms, but nothing near the panic that caused Wall Street executives to bombard the Treasury secretary, Henry M. Paulson Jr., with dire warnings about a Bear Stearns collapse in March.
Fed officials also saw few signs that fears about the future of the investment bank were spilling over to fears about its customers and trading partners.
Bloomberg News reported that the prices of credit-default swaps, used to insure against losses on a bond default, for financial institutions like Goldman Sachs and Morgan Stanley were below the record highs they reached when Bear Stearns was collapsing in March. The cost of credit insurance is an indicator of investor anxiety.
Experts cautioned that Washington officials might yet capitulate, and people close to the talks said it remained possible that any deal Lehman might reach this weekend to sell itself to one or more suitors could still unravel.
And in practice, taxpayers could still end up on the hook for at least as much money as they were in the case of Bear Stearns. Lehman’s successor will still be able to borrow from the Fed’s new lending program for major investment banks, which the Fed created in response to the collapse of Bear Stearns in March. If Lehman were to borrow money and then default on its loans, the Fed’s losses would reduce the amount of money it turns over to the Treasury.
For political and economic reasons, both the Federal Reserve and the Treasury Department are loath to save financial institutions from their own folly.
But as the housing crisis has deepened, they have abandoned free-market orthodoxy, fearing that the collapse of institutions like Bear Stearns or either Fannie Mae or Freddie Mac could cripple the financial markets, and perhaps the economy itself.
Treasury and Fed officials are still making up the rules as they go and relying heavily on judgment. If they do see a panic in the marketplace, the hard talk about tough love is likely to evaporate.
One of the biggest differences between the challenge facing Lehman and the one that faced Bear Stearns is the availability of the Fed’s emergency lending program for investment banks.
When confidence evaporated in Bear, with major hedge funds pulling their prime brokerage accounts, Bear’s financing ran out almost overnight, creating a panic situation. Lehman has had the power to plug any cash shortfalls by borrowing from the Fed, though it has not actually borrowed any money from the program since March.
Fed officials would much rather that Lehman or the company that acquires it stay away from its the lending program, because the Fed would be forced to hold collateral from Lehman in the form of hard-to-sell assets, like mortgage-backed securities.
The more the central bank’s balance sheet becomes loaded with less-liquid assets, like mortgage-backed securities, the less flexibility it has to increase the supply of cash to counter unexpected economic shocks. The Federal Reserve is already holding $29 billion worth of securities from Bear Stearns, and it has been lending hundreds of billions of dollars in exchange to banks and other depository institutions.
Treasury and Fed officials appear to be seeking the kind of solution for Lehman that the Fed engineered for Long Term Capital Management, the huge hedge that collapsed and set off shock waves across the financial markets. In that case, officials at the Federal Reserve Bank of New York coaxed some of the hedge fund’s biggest creditor banks into providing enough capital to get through the crisis. No public money was involved.
Industry analysts said Lehman’s financial position was less acute than that of Bear Stearns last March, in part because Lehman has not relied nearly as much on short-term funding that can evaporate if customers become nervous.
“We can think of Lehman as a company that is in an emergency room and is on a Fed ‘ventilator’ that keeps funding flowing to it,” said Brad Hintz, an analyst at Sanford Bernstein. “The challenge is getting off the ventilator. Right now there is no easy way for the firm to do it itself.”
Despite their professions of outward calm, Fed and Treasury officials were working intensively to hammer out a deal for Lehman by Sunday evening, hopefully before Asian markets open.
Even if the government does not provide any money to smooth the deal, officials may well agree to relax some of their rules for potential suitors. Bank of America, for example, would be likely to ask for temporary relief from the minimum-capital requirements on banks. Bank of America is also bumping up against federal rules that prohibit banks from controlling 10 percent of all deposits in the country.
If any concessions on capital requirements were temporary, they would pose little risk to taxpayers. But if they were offered over an indefinite period, they would add to the financial risks that already threaten to overwhelm the Federal Deposit Insurance Corporation.
Not all of Wall Street was sanguine about the government’s position. “We do not believe the central bank can allow a broker to fail as this would release an avalanche of unquantifiable systemic risk into the global bond markets and the Federal Reserve clearly does not want this to happen,” Mr. Hintz, the analyst, wrote in a report last week.
